Europe’s Inflation Outlook Depends on How Corporate Profits Absorb Wage Gains

IMF Blog, June 26, 2023

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Inflation in the euro area peaked at 10.6 percent in October 2022.
Inflation retreated to 6.1 percent in May.
Core inflation has proven more persistent and is keeping pressure on the ECB.
Policymakers raised rates to a 22-year high of 3.5 percent in June.
Rising corporate profits account for almost half the increase in Europe’s inflation over the past two years.
Profits accounted for 45 percent of price rises since the start of 2022.
Import costs accounted for about 40 percent of inflation since the start of 2022.
Labor costs accounted for 25 percent of inflation since the start of 2022.
Taxes had a slightly deflationary impact.

Profits (adjusted for inflation) were about 1 percent above their pre-pandemic level in the first quarter of this year.
Compensation of employees (adjusted for inflation) was about 2 percent below trend in the first quarter of this year.
Workers saw their wages drop by about 5 percent in real terms in 2022.
Wages respond with a lag to price shocks because wage negotiations are held infrequently.

Baseline wage assumption: nominal wages rise at a pace of around 4.5 percent over the next two years (slightly below the growth rate seen in the first quarter of 2023) and labor productivity stays broadly flat in the next couple of years.
- Under this assumption and assuming commodity prices continue to decline (as projected in April’s World Economic Outlook), businesses’ profit share would have to fall back to pre-pandemic levels for inflation to reach the ECB’s 2-percent target by mid-2025.
Faster wage scenario: nominal wages increase by 5.5 percent (the rate needed to guide real wages back to their pre-pandemic level by end-2024).
- Under this scenario, the profit share would have to drop to the lowest level since the mid-1990s (barring any unexpected increase in productivity) for inflation to return to target.

Macroeconomic policies need to remain tight to anchor expectations and maintain subdued demand.
Tight policy would coax firms to accept a compression of the profit share, allowing real wages to recover at a measured pace.
The extent to which companies absorb higher wage costs (reducing profit margins) versus pass them on to prices will determine the inflation path toward the ECB’s 2-percent target.

Niels-Jakob Hansen, Frederik Toscani, Jing Zhou — June 26, 2023